NEW YORK Feb 28 The market turbulence of last year's "taper tantrum" is likely to return when the Federal Reserve decides to raise interest rates, some top U.S. economists concluded in a research paper that warns that more policy stimulus today can spark bigger disruptions in the future.
The paper, published on Friday, focused on the May-June taper tantrum, when then Fed Chairman Ben Bernanke's talk of less stimulus sparked a market drop, as well as on this year's sell-off in emerging markets. It argues that investors in mutual funds, though unleveraged relative to more tightly regulated banks, can destabilize things when they rush to sell.
The paper questioned whether the central bank was successful in explaining to the public its true intentions in mid-2013, and thus was able to stop any further bouts of selling, as some Fed policymakers contend. It also suggested the economy faces bigger risks the longer the Fed keeps rates near zero.
"Whenever the decision to tighten policy is made, then the instability seen in summer of 2013 is likely to reappear. Hence, risks of instability have not been eliminated," wrote JPMorgan chief U.S. economist Michael Feroli, Anil Kashyap, a professor at The University of Chicago Booth School of Business, both former Fed officials, and two other well-respected economists.
They cited as supporting evidence the turbulence earlier this year in the currencies and stocks of Turkey, Argentina and other emerging economies, which also depressed U.S. equities. And they noted that the Fed can be blamed regardless of whether its actions in fact caused the market disruption.
The paper, also co-authored by Princeton University professor Hyun Song Shin and Kermit Schoenholtz of New York University, was presented at a high-profile economics conference attended by Fed Governor Jeremy Stein, Chicago Fed President Charles Evans, and other policymakers.
After more than five years of ultra-accommodative policies in the wake of the recession, the Fed is taking the first steps to wind them down. It modestly trimmed a bond-buying program in each of the last two months, and it plans to raise rates some time next year, as long as the economy continues to improve.
Interest rates have been near zero since the worst of the financial crisis in late 2008; the Fed has meanwhile swollen its balance sheet to more than $4 trillion in a further attempt to stimulate investment, hiring and growth.
Fed policymakers are wary however that their stated plans for future policy actions, known as forward guidance, can cause borrowing costs to soar.
In May, after Bernanke told a congressional hearing that the asset purchases could be tapered in "the next few meetings," the yield on the 10-year U.S. Treasury bond jumped from 2.04 percent to 2.54 percent over a month.
'NOT A FREE LUNCH'
The risk that all this easy money could bring about financial instabilities has stoked debate within the Fed over whether policymakers should stand ready to raise rates earlier than planned to snuff out those risks.
Daniel Tarullo, a Fed governor and its top bank regulator, said on Tuesday the central bank should not rule out using monetary policy to combat asset price bubbles that potentially threaten financial stability.
In the paper, the economists concluded that the current policy stimulus "is not a free lunch" and can bring about disruptions when that accommodation is lifted.
"Perhaps the domestic macroeconomic fallout from exit will be as gentle as was the impact from the 2013 'taper tantrum,'" they wrote. "However, such a benign outcome is not guaranteed: while tapering is now under way, monetary policy remains highly accommodative, so a meaningful exit has yet to occur."
Standing back, the economists argue that the Fed's two key stimulus efforts, the bond buying and the forward guidance, "can build future hazards by encouraging certain types of risk-taking that are not easily reversed in a controlled manner."
The paper also underlines a concern that Tarullo and Stein have raised in the past: that regulatory tools may not be enough to stamp out risks in harder-to-detect corners of financial markets.
The usual tools of monitoring banks - bank capital ratios and liquidity requirements, among other regulations - fail to address instabilities that mutual fund investors, for example, can cause when they rush for the exits, the economists wrote.
The 55-page paper examined bond flows from mutual funds, and noted that investors do not want to be the last out of a trade.
It finds that banks need not take action to spark market tantrums, suggesting that too-big-to-fail banks should not be the sole focus of regulators looking to stabilize markets.
The "absence of leverage may not be sufficient to ensure that monetary policy can disregard concerns for financial stability," the paper said.